China's new leaders face tough economic choices

China's economic model that delivered three decades of double-digit growth is running out of steam and the country's next leaders face tough choices to keep incomes rising. But they don't seem to have ambitious solutions. Even if they do, they will need to tackle entrenched interests with backing high in the Communist Party.

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China's economic model that delivered three decades of double-digit growth is running out of steam and the country's next leaders face tough choices to keep incomes rising. But they don't seem to have ambitious solutions. Even if they do, they will need to tackle entrenched interests with backing high in the Communist Party.

The cost of inaction could be high. The World Bank says without change, annual growth could sink to 5 percent by 2015 - dangerously low by Chinese standards. Some private sector analysts give even gloomier warnings.

The government's own advisers say it needs to promote service industries and consumer spending, shifting away from reliance on exports and investment. That will require opening more industries to entrepreneurs and forcing cosseted state companies to compete. State banks would have to lend more to private business that is starved for credit.

The ruling party's latest five-year development plan promises reforms in broad terms. Premier Wen Jiabao apologized at a news conference in March for not moving fast enough and vowed quicker action. But many changes could face opposition from China's most influential factions - state companies, their allies in the party, bureaucrats and local leaders.

"If the challenge is, can they do radical reform all at once, we know that won't happen because these leaders aren't powerful enough," said Scott Kennedy, director of Indiana University's Research Center for Chinese Politics & Business in Beijing. "They are facing interests which wouldn't possibly allow that to occur."

Also at issue is how much Communist Party leaders are willing to cut back state industry that provides jobs and money to underpin the party's monopoly on power.

Li Keqiang is the man in line to lead reforms as the next premier, China's top economic official. Now a vice premier, Li is seen as a political insider with an easygoing style, not a hard-driving reformer. Along with the rest of the party's Standing Committee, the ruling inner circle due to be installed in November, Li will govern by consensus, which could blunt their force.

"They are under pressure to change the economy, but they will not demolish party control," said Mao Yushi, an 83-year-old economist who is one of China's most prominent reform advocates. He co-founded the Unirule Institute of Economics, an independent think tank in Beijing.

Li showed his political skills but little zeal for reform as governor and later party secretary of populous Henan province in 1998-2004.

His time there coincided with several fatal fires - including a Christmas Day blaze at a nightclub in 2000 that killed 309 people - and efforts by local officials to suppress information about the spread of AIDS by a blood-buying industry. Other officials were punished for the fires but Li emerged unscathed and rose to national office.

"Li was known for not acting very aggressively in Henan, to put it charitably," said Dali Yang, a University of Chicago political scientist.

The man in line to become Communist Party leader and China's president, Xi Jinping, has a similar reputation for successful inaction.

In the 1990s, he served as party secretary of Zhejiang province, a thriving center for private business south of Shanghai, and won praise from observers including former U.S. Treasury Secretary Henry Paulson, who dealt with him as an investment banker. They lauded him not for spearheading change but for not tampering with Zhejiang's free-market success.

The next leadership will inherit one of the world's strongest economies but one in which advocates say reform is stalled.

Many observers trace the past decade of double-digit growth to changes forced through by former Premier Zhu Rongji, who overcame resistance from companies and party factions to slash the size of state industry in the late 1990s. He led Beijing into the free-trading World Trade Organization, driving a jump in trade growth that propelled China past Germany in 2009 as the world's biggest exporter.

After Zhu retired in 2002, leaders reaped the financial benefits but focused on other areas: reforms of the legal system and trying to close a yawning gap between rich and poor with more spending on health and other social services.

They built up state-owned "national champions" in industries from oil and telecoms to steel and banking with monopolies, low-cost bank loans and other favors. Beijing's huge stimulus after the 2008 global crisis flowed through state companies, increasing their dominance while entrepreneurs who generate China's new jobs and wealth struggled.

The government defends the privileges given to its oil, telecoms and other major companies as necessary for building up Chinese global competitors. But entrepreneurs complain those companies abuse their control over essential resources such as energy, phone service and bank loans to gouge customers and pay their managers inflated salaries while stifling job-creating private businesses.

In a report last year, Mao's institute calculated the biggest state companies consumed trillions of yuan (hundreds of billions of dollars) in subsidies over the previous decade. It said they are so inefficient that their return on equity - a broad measure of profitability - was an average loss of 6 percent a year.

Wen Jia, a manager for the privately owned Traveling Bestone travel agency in the western province of Chengdu, said her company struggles to compete in an industry that is hemmed in by state companies.

"The attractions belong to the state. So do some of the good hotels. The insurance, airlines and train tickets are the same," said Wen. "State-owned travel agencies get prices 10 percent lower than we do on attractions and state-owned hotels."

The abrupt economic slowdown that began last year has heightened frustration among entrepreneurs and the public. Growth fell to 7.4 percent in the latest quarter, its lowest level since early 2009 and barely half of 2007's explosive 14.2 percent.

""The criticism is about how the distortions are not just benefiting those vested interests but also that they reduce the efficiency of the economy," said Yang. "The pressures in the economy paradoxically provide them with more of a mandate for doing things because they have to do things."

The World Bank and a Cabinet think tank, the Development Research Center, offered an ambitious roadmap for reform with a report in March that called for scaling back state industry and opening markets to private and foreign competitors. It warned that without change, China might be trapped at its current middle-income levels.

"The difference that reforms can make is the difference between a 6 to 7 percent growth pace and no growth at all," said Societe General economist Wei Yao in a report.

Supporters of reform were encouraged by the fact that both current Premier Wen Jiabao and Li, his likely successor, supported the research that went into the World Bank report. They were disappointed when Li failed to endorse its recommendations, though he might have remained silent to avoid stirring up opposition ahead of the leadership transition.

Changes to state industry will be politically sensitive. Companies that oppose giving up monopolies and other favors can argue that they provide tax revenue, provide money to develop poor ethnic minority areas and pay for ambitious but unprofitable initiatives such as developing homegrown mobile phone technology.

Bosses of the biggest companies are appointed by the party and are politically influential. Some will take part in the November party congress to install the next leadership. Their companies also create a cadre of well-paid executives and other professionals who form a base of support for continued one-party rule.

"State-owned enterprise bosses are very powerful. They outrank the people who are supposed to regulate them," said James McGregor, an American businessman in Beijing and author of the new book "No Ancient Wisdom, No Followers: The Challenges of Chinese Authoritarian Capitalism."

"That's going to be a very hard thing to break. But the countervailing pressure is that growth can't keep going unless they loosen up," McGregor said. "The party's only credibility is making life better, and if that doesn't happen, how do you maintain stability?"